Introduction

In the seem­ing­ly nev­er-end­ing after­math to the eco­nom­ic cri­sis that began in 2007, there is lit­tle dis­agree­ment that finan­cial mar­kets are char­ac­ter­ized by insta­bil­i­ty rather than sta­bil­i­ty. Even Eugene Fama, the most influ­en­tial pro­po­nent of the Cap­i­tal Assets Pric­ing Mod­el (CAPM; Fama 1970), now acknowl­edges that CAPM is strong­ly con­tra­dict­ed by the data:

The attrac­tion of the CAPM is that it offers pow­er­ful and intu­itive­ly pleas­ing pre­dic­tions about how to mea­sure risk and the rela­tion between expect­ed return and risk. Unfor­tu­nate­ly, the empir­i­cal record of the mod­el is poor—poor enough to inval­i­date the way it is used in appli­ca­tions… whether the mod­el’s prob­lems reflect weak­ness­es in the the­o­ry or in its empir­i­cal imple­men­ta­tion, the fail­ure of the CAPM in empir­i­cal tests implies that most appli­ca­tions of the mod­el are invalid. (Fama and French 2004, p. 25)

CAP­M’s empir­i­cal demise as a the­o­ry of finance has been accom­pa­nied by the rise of behav­iour­al finance, which attrib­ut­es much of the insta­bil­i­ty of finance mar­kets to the lim­it­ed and heuris­ti­cal­ly ori­ent­ed cog­ni­tive capac­i­ties of actu­al traders (Kah­ne­man and Tver­sky 1979; Kah­ne­man 2003). While this is clear­ly an impor­tant aspect of insta­bil­i­ty, I will take a dif­fer­ent tack and sit­u­ate my expla­na­tion in the inte­grat­ed macro-finan­cial vision of Hyman Min­sky’s Finan­cial Insta­bil­i­ty Hypoth­e­sis (FIH). Pre­vi­ous papers have applied Min­sky’s vision to macro­eco­nom­ics (Keen 1995; Keen 1997; Keen 2000; Keen 2011); in this paper I will focus on the impli­ca­tions of Min­sky’s analy­sis for the behav­iour of finan­cial mar­kets.

A lengthy pre­lude is nec­es­sary before I con­sid­er Min­sky’s analy­sis of finan­cial mar­kets, since past expe­ri­ence has shown that a neo­clas­si­cal per­spec­tive on eco­nom­ics (which the vast major­i­ty of pol­i­cy mak­ers have, as well as most econ­o­mists) obstructs com­pre­hen­sion of the link Min­sky pos­tu­lates between debt and asset prices.

A Primer on Minsky

Min­sky enjoyed a strong fol­low­ing amongst Post Key­ne­sian econ­o­mists, but he was almost com­plete­ly ignored by neo­clas­si­cal econ­o­mists before the cri­sis. Bernanke’s treat­ment of him is not atyp­i­cal:

Hyman Min­sky (1977) and Charles Kindle­berg­er (1978) have in sev­er­al places argued for the inher­ent insta­bil­i­ty of the finan­cial sys­tem but in doing so have had to depart from the assump­tion of ratio­nal eco­nom­ic behav­iour… [A foot­note adds] I do not deny the pos­si­ble impor­tance of irra­tional­i­ty in eco­nom­ic life; how­ev­er it seems that the best research strat­e­gy is to push the ratio­nal­i­ty pos­tu­late as far as it will go. (Bernanke 2000, p. 43)

Now, after the cri­sis that his the­o­ry antic­i­pat­ed, neo­clas­si­cal econ­o­mists are pay­ing some atten­tion to his hypoth­e­sis, and there has been at least one attempt to build a New Key­ne­sian mod­el of a key phe­nom­e­non in Min­sky’s hypoth­e­sis, a debt-defla­tion (Krug­man and Eggerts­son 2010). How­ev­er, to those of us who are not new to Min­sky, it is hard to recog­nise any ves­tige of the Finan­cial Insta­bil­i­ty Hypoth­e­sis in Krug­man’s work. This reac­tion is based not mere­ly on Min­sky’s explic­it denial that his hypoth­e­sis could be mod­elled from a neo­clas­si­cal per­spec­tive (Min­sky 1982 , p. 5), but on ways in which it is strict­ly incom­pat­i­ble with New Key­ne­sian method­ol­o­gy. There are many facets to this, but I will focus on two that are cru­cial to the link between the FIH and finan­cial mar­ket insta­bil­i­ty: dis­e­qui­lib­ri­um and endoge­nous mon­ey.

Disequilibrium

Min­sky pre­cur­sors Schum­peter and Fish­er accept­ed that cap­i­tal­ism was always in dis­e­qui­lib­ri­um. Schum­peter saw insta­bil­i­ty as intrin­sic to cap­i­tal­ism, and regard­ed it as not a flaw, but as the source of cap­i­tal­is­m’s vital­i­ty (Schum­peter 1928). Fish­er, as an apos­tate from neo­clas­si­cal equi­lib­ri­um mod­el­ling after the Great Depres­sion ruined him, put the neces­si­ty for dis­e­qui­lib­ri­um mod­el­ling very clearly—even for those who believe that cap­i­tal­ism is fun­da­men­tal­ly sta­ble. Fish­er argued that, even if a ten­den­cy towards equi­lib­ri­um is assumed, as a mat­ter of fact, all eco­nom­ic vari­ables will be in dis­e­qui­lib­ri­um at all times in the real econ­o­my. Eco­nom­ics the­o­ry there­fore must be dis­e­qui­lib­ri­um in nature:

‘We may ten­ta­tive­ly assume that, ordi­nar­i­ly and with­in wide lim­its, all, or almost all, eco­nom­ic vari­ables tend, in a gen­er­al way, toward a sta­ble equi­lib­ri­um… But … New dis­tur­bances are, human­ly speak­ing, sure to occur, so that, in actu­al fact, any vari­able is almost always above or below the ide­al equi­lib­ri­um…

The­o­ret­i­cal­ly there may be—in fact, at most times there must be—over-or under-pro­duc­tion, over- or under-con­sump­tion, over- or under-spend­ing, over- or under-sav­ing, over- or under-invest­ment, and over or under every­thing else. It is as absurd to assume that, for any long peri­od of time, the vari­ables in the eco­nom­ic orga­ni­za­tion, or any part of them, will “stay put,” in per­fect equi­lib­ri­um, as to assume that the Atlantic Ocean can ever be with­out a wave.’ (Fish­er 1933, p. 339; empha­sis added)

Min­sky went fur­ther than Schum­peter and Fish­er to argue that equi­lib­ri­um itself was inher­ent­ly unsta­ble, and con­tained the seeds of dis­as­ter as well as of boun­ty. Because sta­bil­i­ty was the excep­tion rather than the norm in a cap­i­tal­ist econ­o­my, any peri­od of sta­bil­i­ty will have been pre­ced­ed by a more tur­bu­lent time; and because the future was uncer­tain, a peri­od of tran­quil­li­ty would lead to cap­i­tal­ists revis­ing their expec­ta­tions upwards:

Sta­ble growth is incon­sis­tent with the man­ner in which invest­ment is deter­mined in an econ­o­my in which debt-financed own­er­ship of cap­i­tal assets exists, and the extent to which such debt financ­ing can be car­ried is mar­ket deter­mined. It fol­lows that the fun­da­men­tal insta­bil­i­ty of a cap­i­tal­ist econ­o­my is upward. The ten­den­cy to trans­form doing well into a spec­u­la­tive invest­ment boom is the basic insta­bil­i­ty in a cap­i­tal­ist econ­o­my. (Min­sky 1982, p. 67)

Min­sky’s clas­sic phrase that “Sta­bil­i­ty … is desta­bi­liz­ing” (Min­sky 1982, p. 101) encap­su­lates his cycli­cal vision of cap­i­tal­ism. Any attempt to shoe­horn this into the com­par­a­tive sta­t­ic, shift­ing equi­lib­ri­um method­ol­o­gy of New Key­ne­sian macro­eco­nom­ics is cer­tain to car­i­ca­ture his analy­sis rather than do it jus­tice.

Endogenous Money

Banks play a cru­cial role in Min­sky’s analy­sis because they can endoge­nous­ly expand the mon­ey sup­ply in response to entre­pre­neur­ial or Ponzi Finance demands for funds. This empha­sis upon the cru­cial role of banks can be traced back to Min­sky’s PhD advi­sor Schum­peter, who argued that invest­ment is not financed by sav­ings, but by the endoge­nous expan­sion of the mon­ey sup­ply by banks:

Even though the con­ven­tion­al answer to our ques­tion is not obvi­ous­ly absurd, yet there is anoth­er method of obtain­ing mon­ey for this pur­pose, which … does not pre­sup­pose the exis­tence of accu­mu­lat­ed results of pre­vi­ous devel­op­ment, and hence may be con­sid­ered as the only one which is avail­able in strict log­ic. This method of obtain­ing mon­ey is the cre­ation of pur­chas­ing pow­er by banks… It is always a ques­tion, not of trans­form­ing pur­chas­ing pow­er which already exists in some­one’s pos­ses­sion, but of the cre­ation of new pur­chas­ing pow­er out of noth­ing. (Schum­peter 1934, p. 73)

Schum­peter thus saw invest­ment as being pri­mar­i­ly financed not out of income, but out of the increase in the mon­ey sup­ply caused by banks issu­ing loans to entrepreneurs—where this increase in the mon­ey sup­ply was exact­ly matched by and caused by an increase in debt.

Schum­peter’s entire­ly the­o­ret­i­cal argu­ments on both the nature of bank­ing and the ulti­mate source of finance for invest­ment received sub­se­quent sup­port from empir­i­cal researchers. Basil Moore (Moore 1979; Min­sky, Nell et al. 1991) over­turned the “mon­ey mul­ti­pli­er” mod­el of mon­ey cre­ation with empir­i­cal research which showed that bank lend­ing pre­ced­ed reserve cre­ation (see also Holmes 1969; Car­pen­ter and Demi­ralp 2010). Fama and French con­clud­ed that cor­re­la­tions they found between invest­ment and the change in cor­po­rate debt lev­els “con­firm the impres­sion that debt plays a key role in accom­mo­dat­ing year-by-year vari­a­tion in invest­ment.” (Fama and French 1999, p. 1954)

How­ev­er, ris­ing debt does not only finance invest­ment: it also finances spec­u­la­tion. Enter Min­sky, who extend­ed Schum­peter by con­sid­er­ing the demands of Ponzi Financiers as well. These bor­row­ers do not invest, but buy exist­ing assets and hope to prof­it by sell­ing those assets on a ris­ing mar­ket. There­fore, unlike Schum­peter’s entre­pre­neurs, whose debts today can be ser­viced and repaid from prof­its tomor­row, Ponzi Financiers always have debt ser­vic­ing costs that exceed the cash flows from the assets they pur­chased with bor­rowed mon­ey. They there­fore must expand their debts or sell assets to con­tin­ue func­tion­ing:

A Ponzi finance unit is a spec­u­la­tive financ­ing unit for which the income com­po­nent of the near term cash flows falls short of the near term inter­est pay­ments on debt so that for some time in the future the out­stand­ing debt will grow due to inter­est on exist­ing debt… Ponzi units can ful­fil their pay­ment com­mit­ments on debts only by bor­row­ing (or dis­pos­ing of assets)… a Ponzi unit must increase its out­stand­ing debts. (Min­sky 1982, p. 24)

Schum­peter and Min­sky both saw cred­it mon­ey cre­at­ed by the bank­ing sys­tem as the source of the aggre­gate demand in excess of income. Min­sky put this explic­it­ly:

If income is to grow, the finan­cial mar­kets, where the var­i­ous plans to save and invest are rec­on­ciled, must gen­er­ate an aggre­gate demand that, aside from brief inter­vals, is ever ris­ing. For real aggre­gate demand to be increas­ing, … it is nec­es­sary that cur­rent spend­ing plans, summed over all sec­tors, be greater than cur­rent received income and that some mar­ket tech­nique exist by which aggre­gate spend­ing in excess of aggre­gate antic­i­pat­ed income can be financed. It fol­lows that over a peri­od dur­ing which eco­nom­ic growth takes place, at least some sec­tors finance a part of their spend­ing by emit­ting debt or sell­ing assets. (Min­sky 1963; Min­sky 1982) (Min­sky 1982, p. 6; empha­sis added)

This endoge­nous mon­ey per­spec­tive thus tran­scends Wal­ras’ Law, which plays such a key role in Neo­clas­si­cal equi­lib­ri­um mod­el­ling but is valid only in an econ­o­my with­out banks. In a cred­it econ­o­my, a dynam­ic dis­e­qui­lib­ri­um “Wal­ras-Schum­peter-Min­sky’s Law” applies instead: aggre­gate demand is income plus the change in debt, and this is expend­ed on both goods and ser­vices and finan­cial assets. There­fore in a cred­it-based econ­o­my, there are three sources of aggre­gate demand, and three ways in which this demand is expend­ed:

Demand from income earned by sell­ing goods and ser­vices, which pri­mar­i­ly finances con­sump­tion of goods and ser­vices;

Demand from ris­ing entre­pre­neur­ial debt, which pri­mar­i­ly finances invest­ment; and

Demand from ris­ing Ponzi debt, which pri­mar­i­ly finances the pur­chase of exist­ing assets.

Neoclassical misinterpretations of Fisher, Minsky & Banking

The endoge­nous cre­ation of mon­ey by banks means that the lev­el and rate of change of pri­vate debt play cru­cial roles in Min­sky’s macro­eco­nom­ics. In con­trast, neo­clas­si­cal the­o­ry treats banks as mere inter­me­di­aries between savers and bor­row­ers, for­mal­ly ignores them in DSGE mod­el­ling, and treats the lev­el and rate of change of pri­vate debt as macro­eco­nom­i­cal­ly unim­por­tant. Before the cri­sis, Bernanke dis­missed Fish­er’s debt-defla­tion expla­na­tion for the Great Depres­sion:

because of the coun­ter­ar­gu­ment that debt-defla­tion rep­re­sent­ed no more than a redis­tri­b­u­tion from one group (debtors) to anoth­er (cred­i­tors). Absent implau­si­bly large dif­fer­ences in mar­gin­al spend­ing propen­si­ties among the groups, it was sug­gest­ed, pure redis­tri­b­u­tions should have no sig­nif­i­cant macro-eco­nom­ic effects. (Bernanke 2000, p. 24)

Even after the cri­sis, when pri­vate debt had to be acknowl­edged as a fac­tor, neo­clas­si­cal mod­ellers insist­ed that the aggre­gate lev­el of debt was unimportant—only its dis­tri­b­u­tion could mat­ter:

Ignor­ing the for­eign com­po­nent, or look­ing at the world as a whole, the over­all lev­el of debt makes no dif­fer­ence to aggre­gate net worth — one per­son­’s lia­bil­i­ty is anoth­er per­son­’s asset…

In what fol­lows, we begin by set­ting out a flex­i­ble-price endow­ment mod­el in which “impa­tient” agents bor­row from “patient” agents, but are sub­ject to a debt lim­it. If this debt lim­it is, for some rea­son, sud­den­ly reduced, the impa­tient agents are forced to cut spend­ing… (Krug­man and Eggerts­son 2010, p. 3)

Krug­man reassert­ed this analy­sis in a recent blog, argu­ing that the lev­el of debt does­n’t mat­ter, because debt is “mon­ey we owe to our­selves”:

Peo­ple think of debt’s role in the econ­o­my as if it were the same as what debt means for an indi­vid­ual: there’s a lot of mon­ey you have to pay to some­one else. But that’s all wrong; the debt we cre­ate is basi­cal­ly mon­ey we owe to our­selves, and the bur­den it impos­es does not involve a real trans­fer of resources.

That’s not to say that high debt can’t cause prob­lems — it cer­tain­ly can. But these are prob­lems of dis­tri­b­u­tion and incen­tives, not the bur­den of debt as is com­mon­ly under­stood. (Krug­man 2011)

The flaw in this neo­clas­si­cal approach to debt and bank­ing is eas­i­ly illus­trat­ed using book­keep­ing tables. In the fol­low­ing two tables, trans­ac­tions are shown from the bank’s point of view, so that cred­it­ing an account by an increase in deposits is shown as a neg­a­tive (since deposits are a lia­bil­i­ty for the bank) and deb­it­ing an account by an increase in debt is shown as a pos­i­tive (since loans are an asset). The neo­clas­si­cal vision of sav­ing as mod­elled by Krug­man (after insert­ing an implic­it bank­ing sec­tor into Krug­man’s bank-less mod­el) is shown in Table 1. From this per­spec­tive, lend­ing makes no dif­fer­ence to the lev­el of aggre­gate demand (unless the impa­tient agent has a marked­ly high­er propen­si­ty to spend) because lend­ing does not change the amount of mon­ey in circulation—it only alters its dis­tri­b­u­tion.

Table 1: Neo­clas­si­cal per­spec­tive on lend­ing

Assets

Deposits (Lia­bil­i­ties)

Action/Actor

Patient

Impa­tient

Make Loan

+Lend

-Lend

The endoge­nous mon­ey vision is shown in Table 2. From this per­spec­tive, lend­ing increas­es the amount of mon­ey in cir­cu­la­tion, and adds to the spend­ing pow­er of the “Impa­tient agent” (in prac­tice, nor­mal­ly either an investor or a Ponzi spec­u­la­tor) with­out sub­tract­ing from the spend­ing pow­er of the “Patient agent”. Aggre­gate demand there­fore ris­es by the increase in debt.

Table 2: Endoge­nous mon­ey per­spec­tive on lend­ing

Bank Assets

Bank Deposits (Lia­bil­i­ties)

Action/Actor

Patient

Impa­tient

Make Loan

+Lend

-Lend

Table 2 is not only more faith­ful to Min­sky’s vision: it is also more real­is­tic. Real world lend­ing is not a trans­fer of mon­ey from one depos­i­tor’s account to anoth­er’s, but a con­tract between a bank and a bor­row­er in which the bank cred­its the bor­row­er’s account (thus increas­ing the bank’s lia­bil­i­ties) in return for the bor­row­er agree­ing to be in debt to the bank for the same amount (thus increas­ing the bank’s assets). This increas­es the aggre­gate amount of mon­ey in cir­cu­la­tion, increas­ing aggre­gate demand in the process—and pre­dom­i­nant­ly financ­ing invest­ment or spec­u­la­tion rather than con­sump­tion. Con­trary to neo­clas­si­cal a pri­ori log­ic, the lev­el of pri­vate debt has seri­ous macro­eco­nom­ic effects, and plays a dom­i­nant role in set­ting asset prices.

The pri­ma­ry focus of this paper is the lat­ter, but giv­en the extent to which macro­eco­nom­ics and finance are inter­twined in Min­sky’s work, I would be remiss not to cov­er his inte­grat­ed vision of finan­cial macro­eco­nom­ics. The next sec­tion is an abridged extract from Keen (1995).

Minsky on Debt-driven booms and busts

Min­sky’s analy­sis of a finan­cial cycle begins at a time when the econ­o­my is doing well, but firms are con­ser­v­a­tive in their port­fo­lio man­age­ment, and this con­ser­vatism is shared by banks. The cause of this high and uni­ver­sal­ly prac­ticed risk aver­sion is the mem­o­ry of a not too dis­tant sys­tem-wide finan­cial fail­ure, when many invest­ment projects foundered, many firms could not finance their bor­row­ings, and many banks had to write off bad debts. Because of this recent expe­ri­ence, both sides of the bor­row­ing rela­tion­ship pre­fer extreme­ly con­ser­v­a­tive esti­mates of prospec­tive cash flows: their risk pre­mi­ums are very high.

How­ev­er, the com­bi­na­tion of a grow­ing econ­o­my and con­ser­v­a­tive­ly financed invest­ments means that most projects suc­ceed. Two things grad­u­al­ly become evi­dent to man­agers and bankers: “Exist­ing debts are eas­i­ly val­i­dat­ed and units that were heav­i­ly in debt pros­pered: it pays to lever” (Min­sky 1982, p. 65). As a result, both man­agers and bankers come to regard the pre­vi­ous­ly accept­ed risk pre­mi­um as exces­sive. Invest­ment projects are eval­u­at­ed using less con­ser­v­a­tive esti­mates of prospec­tive cash flows, so that with these ris­ing expec­ta­tions go ris­ing invest­ment and asset prices. The gen­er­al decline in risk aver­sion thus sets off both growth in invest­ment and expo­nen­tial growth in the price lev­el of assets, which is the foun­da­tion of both the boom and its even­tu­al col­lapse.

More exter­nal finance is need­ed to fund the increased lev­el of invest­ment and the spec­u­la­tive pur­chase of assets, and these exter­nal funds are forth­com­ing because the bank­ing sec­tor shares the increased opti­mism of investors. The accept­ed debt to equi­ty ratio ris­es, liq­uid­i­ty decreas­es, and the growth of cred­it accel­er­ates.

This marks the begin­ning of what Min­sky calls “the euphor­ic econ­o­my” (Min­sky 1982, pp. 120–124), where both lenders and bor­row­ers believe that the future is assured, and there­fore that most invest­ments will suc­ceed. Asset prices are reval­ued upward and finan­cial insti­tu­tions now accept lia­bil­i­ty struc­tures for both them­selves and their cus­tomers “that, in a more sober expec­ta­tion­al cli­mate, they would have reject­ed” (Min­sky 1982, p. 123). The liq­uid­i­ty of firms is simul­ta­ne­ous­ly reduced by the rise in debt to equi­ty ratios, mak­ing firms more sus­cep­ti­ble to increased inter­est rates. The gen­er­al decrease in liq­uid­i­ty and the rise in inter­est paid on high­ly liq­uid instru­ments trig­gers a mar­ket-based increase in the inter­est rate, even with­out any attempt by mon­e­tary author­i­ties to con­trol the boom. How­ev­er, the increased cost of cred­it does lit­tle to tem­per the boom, since antic­i­pat­ed yields from spec­u­la­tive invest­ments nor­mal­ly far exceed pre­vail­ing inter­est rates, lead­ing to a decline in the elas­tic­i­ty of demand for cred­it with respect to inter­est rates.

The con­di­tion of eupho­ria also per­mits the devel­op­ment of an impor­tant actor in Min­sky’s dra­ma, the Ponzi financier (Min­sky 1982, pp. 70, 115). These cap­i­tal­ists prof­it by trad­ing assets on a ris­ing mar­ket, and incur sig­nif­i­cant debt in the process. The ser­vic­ing costs for Ponzi debtors exceed the cash flows of the busi­ness­es they own, but the cap­i­tal appre­ci­a­tion they antic­i­pate far exceeds the inter­est bill. They there­fore play an impor­tant role in push­ing up the mar­ket inter­est rate, and an equal­ly impor­tant role in increas­ing the fragili­ty of the sys­tem to a rever­sal in the growth of asset val­ues.

Ris­ing inter­est rates and increas­ing debt to equi­ty ratios even­tu­al­ly affect the via­bil­i­ty of many busi­ness activ­i­ties, reduc­ing the inter­est rate cov­er, turn­ing projects that were orig­i­nal­ly con­ser­v­a­tive­ly fund­ed into spec­u­la­tive ones, and mak­ing ones that were spec­u­la­tive “Ponzi.” Such busi­ness­es will find them­selves hav­ing to sell assets to finance their debt servicing—and this entry of new sell­ers into the mar­ket for assets pricks the expo­nen­tial growth of asset prices. With the price boom checked, Ponzi financiers now find them­selves with assets that can no longer be trad­ed at a prof­it, and lev­els of debt that can­not be ser­viced from the cash flows of the busi­ness­es they now con­trol. Banks that financed these assets pur­chas­es now find that their lead­ing cus­tomers can no longer pay their debts—and this real­iza­tion leads ini­tial­ly to a fur­ther bank-dri­ven increase in inter­est rates. Liq­uid­i­ty is sud­den­ly much more high­ly prized; hold­ers of illiq­uid assets attempt to sell them in return for liq­uid­i­ty. The asset mar­ket becomes flood­ed and the eupho­ria becomes a pan­ic, the boom becomes a slump.

As the boom col­laps­es, the fun­da­men­tal prob­lem fac­ing the econ­o­my is one of exces­sive diver­gence between the debts incurred to pur­chase assets, and the cash flows gen­er­at­ed by them—with those cash flows depend­ing upon both the lev­el of invest­ment and the rate of infla­tion.

The lev­el of invest­ment has col­lapsed in the after­math of the boom, leav­ing only two forces that can bring asset prices and cash flows back into har­mo­ny: asset price defla­tion, or cur­rent price infla­tion. This dilem­ma is the foun­da­tion of Min­sky’s icon­o­clas­tic per­cep­tion of the role of infla­tion, and his expla­na­tion for the stagfla­tion of the 1970s and ear­ly 1980s.

Min­sky argues that if the rate of infla­tion is high at the time of the cri­sis or the debt lev­el is rel­a­tive­ly low, then though the col­lapse of the boom caus­es invest­ment to slump and eco­nom­ic growth to fal­ter, ris­ing cash flows rapid­ly enable the repay­ment of debt incurred dur­ing the boom. The econ­o­my can thus emerge from the cri­sis with dimin­ished growth and high infla­tion, but few bank­rupt­cies and a sus­tained decrease in liq­uid­i­ty. Thus, though this course involves the twin “bads” of infla­tion and ini­tial­ly low growth, it is a self-cor­rect­ing mech­a­nism in that a pro­longed slump is avoid­ed.

How­ev­er, the con­di­tions are soon re-estab­lished for the cycle to repeat itself, and the avoid­ance of a true calami­ty is like­ly to lead to a sec­u­lar decrease in liq­uid­i­ty pref­er­ence. A sec­u­lar trend toward ris­ing debt to equi­ty ratios devel­ops, as each new cycle begins before all debt accu­mu­lat­ed in the last cycle had been repaid. Col­lo­qui­al­ly, firms bor­row dur­ing a boom and repay dur­ing a slump, which gives the debt to income ratio a ten­den­cy to ratch­et up over time, mak­ing the sys­tem more frag­ile.

If the rate of infla­tion is low at the time of the cri­sis and debt lev­els are very high, then cash flows will remain inad­e­quate rel­a­tive to the debt struc­tures in place. Firms whose inter­est bills exceed their cash flows will be forced to under­take extreme mea­sures: they will have to sell assets, attempt to increase their cash flows (at the expense of their com­peti­tors) by cut­ting their mar­gins, or go bank­rupt. In con­trast to the infla­tion­ary course, all three class­es of action tend to fur­ther depress the cur­rent price lev­el, thus at least par­tial­ly exac­er­bat­ing the orig­i­nal imbal­ance. The asset price defla­tion route is, there­fore, not self-cor­rect­ing but rather self-rein­forc­ing, and is Min­sky’s expla­na­tion of a depres­sion.

The above basi­cal­ly describes Min­sky’s per­cep­tion of an econ­o­my in the absence of a gov­ern­ment sec­tor. With big gov­ern­ment, the pic­ture changes in two ways, because of fis­cal deficits and Reserve Bank inter­ven­tions. The col­lapse in cash flows that occurs when a boom becomes a pan­ic is at least part­ly ame­lio­rat­ed by a rise in gov­ern­ment spending—the clas­sic “auto­mat­ic sta­bi­liz­ers,” though this time seen in a more mon­e­tary light. (Keen 1995, pp. 611–614)

That’s the the­o­ry: how well does it stack up against the data? First­ly, the lev­el of pri­vate debt has cer­tain­ly dis­played the sec­u­lar trend that Min­sky iden­ti­fied (see Fig­ure 1).

Fig­ure 1: Aggre­gate Pri­vate and Pub­lic Debt

Sec­ond­ly, Min­sky’s ver­bal mod­el of the cycle also focused pri­mar­i­ly on the bor­row­ing behav­iour of the non-finan­cial busi­ness sec­tor, and here the cycli­cal­i­ty he pre­dict­ed is also obvi­ous. But over­laid on top of it is an expo­nen­tial rise in finance sec­tor debt, as Ponzi Finance became the dis­eased back­bone of the US econ­o­my.

Fig­ure 2: Pri­vate Debt by Sec­tor

Final­ly, the Min­skian dynam­ics of debt also explain what neo­clas­si­cal analy­sis will always find per­plex­ing: the sud­den tran­si­tion from The Great Mod­er­a­tion to The Great Con­trac­tion (Rogoff 2011).

Applying Minsky to Macroeconomic Data

The Wal­ras-Schum­peter-Min­sky propo­si­tion that aggre­gate demand is income plus the change in debt, and that this is expend­ed on both goods and ser­vices and pur­chas­es of finan­cial claims on exist­ing assets, can be put into a sim­ple equa­tion (with Y and D stand­ing for nom­i­nal income and debt lev­els, GDP for the nom­i­nal val­ue of out­put and NAT stand­ing for “Net Asset Turnover”):

Net Asset Turnover can be fac­tored into the price index for assets PA, times their quan­ti­ty QA, times the annu­al turnover TA expressed as a frac­tion of the num­ber of assets :

There will thus be a rela­tion­ship between change in debt and the lev­el of both eco­nom­ic activ­i­ty and asset prices.

Focus­ing on the for­mer for now, it is eas­i­ly shown that the Great Mod­er­a­tion was dri­ven by a sub­stan­tial rise in debt-financed aggre­gate demand, while the Great Con­trac­tion coin­cid­ed with a dra­mat­ic rever­sal from ris­ing to falling debt.

Fig­ure 3: Aggre­gate demand as income plus change in debt

Sim­i­lar­ly, when the rate of change of aggre­gate demand is con­sid­ered, there is a rela­tion­ship between the accel­er­a­tion of debt and both the rate of change of GDP (Big­gs and May­er 2010; Big­gs, May­er et al. 2010) and the change in asset prices:

The rela­tion­ship between the “Cred­it Accelerator”—defined, fol­low­ing (Big­gs and May­er 2010; Big­gs, May­er et al. 2010) as the rate of change of the rate of change in debt per annum, divid­ed by GDP at the midpoint—and change in the employ­ment rate is shown in Fig­ure 2. Far from aggre­gate debt not being macro­eco­nom­i­cal­ly impor­tant, change in employ­ment is strong­ly cor­re­lat­ed with the accel­er­a­tion of debt.

Fig­ure 4: Cred­it Accel­er­a­tion and change in employ­ment

The scale and tim­ing of the down­turn is much eas­i­er to com­pre­hend from Min­sky’s cred­it-based per­spec­tive than the income-only per­spec­tive of neo­clas­si­cal eco­nom­ics. The down­turn in GDP was rel­a­tive­ly minor—from $14.4 tril­lion at its peak to $13.9 tril­lion at its low­point, a fall of just over half a tril­lion or 4% of nom­i­nal GDP—and it com­menced late (in July 2008) and fin­ished ear­ly (in May 2009) com­pared to the cri­sis itself, which is gen­er­al­ly regard­ed as hav­ing start­ed in August 2007 and con­tin­ued get­ting worse in macro­eco­nom­ic terms until late 2009.

The down­turn in pri­vate aggre­gate demand was much more severe: from $18.4 tril­lion at its peak in Novem­ber 2007 to $11.4 tril­lion in Feb­ru­ary 2010, a fall of $6.9 tril­lion or 38% over 2.3 years. The decel­er­a­tion of debt was 5 times greater than any oth­er decel­er­a­tion in the entire post-WWII peri­od, and even stronger than in the Great Depres­sion itself, when the max­i­mum neg­a­tive val­ue of the Cred­it Accel­er­a­tor was ‑18% of GDP.

The pro­found effect of the cri­sis not only on employ­ment and GDP, but also on asset mar­kets, is now far eas­i­er to com­pre­hend.

This now brings us to Min­sky’s dis­tinc­tive argu­ment that there are (at least) two price lev­els in capitalism—one for com­modi­ties and the oth­er for cap­i­tal assets—and his analy­sis of the finan­cial dynam­ics that can wedge them apart dur­ing spec­u­la­tive bub­bles.

Minsky on Finance: Two Price Levels

As a Post Key­ne­sian, Min­sky argued that the prices of most end-con­sumer com­modi­ties are set by a markup on prime cost (Reynolds 1987; Blind­er 1998; Lee 1998). He por­trayed changes in the price lev­el for “cur­rent goods” as main­ly a con­se­quence of cost pres­sures (large­ly from wages and raw mate­ri­als) and changes to markups. The large­ly inde­pen­dent price lev­el of assets is based, not on the orig­i­nal cost of pro­duc­tion of the assets, but on the net present val­ue of antic­i­pat­ed cash flows. These in turn depend on the gen­er­al state of expec­ta­tions, which vary sys­tem­at­i­cal­ly over the finan­cial cycle, lag­ging behind cur­rent prices in a slump, run­ning ahead of them in a recov­ery and boom, and are financed large­ly by Ponzi bor­row­ing. This per­spec­tive allows for sig­nif­i­cant diver­gence between the two price lev­els as expec­ta­tions rise and fall over the medi­um term, and as the growth of debt that finances Ponzi activ­i­ty in asset mar­kets ris­es and falls with them. How­ev­er over the very long term, asset prices must even­tu­al­ly return to some kind of har­mo­ny with cur­rent prices, since the only sus­tain­able sup­port for asset prices is the sales of the com­modi­ties they pro­duce. The price sys­tem thus dis­plays far-from-equi­lib­ri­um dynam­ics, accord­ing to Min­sky, in con­trast to the neo­clas­si­cal argu­ment that the price sys­tem is a sta­bil­is­ing force in a cap­i­tal­ist econ­o­my.

This implies that a sim­ple com­par­i­son of asset prices to con­sumer prices can iden­ti­fy bub­bles, since Min­sky saw no rea­son for a long-term trend for the asset to con­sumer price ratio to rise over time—the only basis for this would be the cap­i­tal­iza­tion of income streams gen­er­at­ed by assets into asset prices. This is fea­si­ble with share prices, giv­en retained earn­ings and in par­tic­u­lar the zero-div­i­dend poli­cies of firms like Berk­shire-Hath­away, but not with house prices.

Even giv­en the exis­tence of a trend to the real share price, the com­mence­ment of the “Great Mod­er­a­tion” share price bub­ble in 1995 is obvi­ous (see Fig­ure 3).

The equa­tion as stat­ed ignores the feed­back rela­tions between income and out­put and change in debt, but even then it indi­cates that the impact of the accel­er­a­tion in debt will be dis­persed through at least five high­ly aggre­gat­ed vari­ables. Clear­ly behav­iour­al sen­ti­ment issues will also affect how much debt is lev­ered into asset mar­kets ver­sus parked else­where. Nonethe­less sig­nif­i­cant cor­re­la­tions exist between debt accel­er­a­tion and real share prices (see Fig­ure 7 and Fig­ure 8), and espe­cial­ly between accel­er­a­tion of mort­gage debt and change in real house prices (see Fig­ure 10).

Fig­ure 5 shows the cor­re­la­tion of the devi­a­tions from trend with the accel­er­a­tion of pri­vate cred­it dur­ing the Roar­ing Twen­ties and the Great Depres­sion (lagged one year since the pre-1950 debt data is end-of-year annu­al only).

The rela­tion­ship between the change in house prices and the accel­er­a­tion of debt since 1990 are more eas­i­ly iden­ti­fied, for three rea­sons. First­ly, there is no need to sub­tract any trend in real house prices pri­or to the bub­ble, since there is no rea­son to expect a trend, and the empir­i­cal data con­firms that there was none. Sec­ond­ly, there is a spe­cif­ic sub­set of debt—mortgage debt—whose accel­er­a­tion can be direct­ly be com­pared to change in real house prices. While some mort­gage debt bleeds into expen­di­ture on oth­er items (espe­cial­ly with “mort­gage equi­ty with­draw­al” loans) and into expand­ing the stock of hous­ing, the major­i­ty of mort­gage debt goes into pur­chas­ing exist­ing hous­ing.

Third­ly, this was the first tru­ly major house price bub­ble in Amer­i­ca’s his­to­ry. Minor bub­bles are evi­dent in 1895, 1979 and 1990, but they are mere Catskills com­pared to the Ever­est of the 2006 bub­ble. The Sub­prime Bub­ble clear­ly began in 1997 (see Fig­ure 7), and burst nine years lat­er. With this data read­i­ly avail­able since 2000 (Shiller 2000), it beg­gars belief that, just 10 months before the peak, Greenspan could assert to Con­gress that there was no nation­al hous­ing bub­ble, and that any house price declines would “not have sub­stan­tial macro­eco­nom­ic impli­ca­tions”:

That said, there can be lit­tle doubt that excep­tion­al­ly low inter­est rates on ten-year Trea­sury notes, and hence on home mort­gages, have been a major fac­tor in the recent surge of home­build­ing and home turnover, and espe­cial­ly in the steep climb in home prices. Although a “bub­ble” in home prices for the nation as a whole does not appear like­ly, there do appear to be, at a min­i­mum, signs of froth in some local mar­kets where home prices seem to have risen to unsus­tain­able lev­els… Although we cer­tain­ly can­not rule out home price declines, espe­cial­ly in some local mar­kets, these declines, were they to occur, like­ly would not have sub­stan­tial macro­eco­nom­ic impli­ca­tions. (Greenspan 2005)

At the time of Greenspan’s tes­ti­mo­ny, the real house price index was 240, a mere 8 per cent below the even­tu­al peak and almost 2.5 times the long term aver­age.

Fig­ure 9: Two price lev­els (prop­er­ty)

The propul­sion for this bub­ble was clear­ly pro­vid­ed by accel­er­at­ing mort­gage debt, and the rapid decel­er­a­tion of debt drove it back down (see Fig­ure 8). Pos­i­tive feed­back loops work in both directions—up and down.

This “Min­skian” per­spec­tive on the role of accel­er­at­ing debt in dri­ving asset price bub­bles leads to sev­er­al obvi­ous con­clu­sions:

The cri­sis will not be over until pri­vate debt has been reduced substantially—to the order of 100% of GDP or less;

Asset prices will fall with the reduc­tion of debt. Even with the 33% decline by Novem­ber 2011, the real house price Index remains 77% above the 1890–1995 aver­age (and 50% above the mini-peak of 1990), while shares are still 67% above the long term trend from 1915–1995;

Ponzi Lend­ing is the key cause of asset price bub­bles;

Since debt can­not per­ma­nent­ly accel­er­ate, all asset bub­bles will ulti­mate­ly burst; and

To avoid asset price bub­bles in the first place, we have to break the pos­i­tive feed­back loop between lever­age and asset prices.

Remedies

If we are to real­ly end the destruc­tive insta­bil­i­ty of the finan­cial sys­tem, we have to address the cause of this insta­bil­i­ty, and from a Min­skian per­spec­tive, that cause is the pos­i­tive feed­back loop between ris­ing debt and asset prices.

This can­not be done sim­ply by rely­ing upon banks learn­ing from the cri­sis and behav­ing more respon­si­bly after it, since they have an innate desire to extend as much debt as they can per­suade the non-bank sec­tors to take on. The rea­son is sim­ple: bank prof­its are dri­ven pri­mar­i­ly by the vol­ume of debt. There is no mys­tery behind why the prof­its and wages of the FIRE econ­o­my have grown rel­a­tive to the rest of the econ­o­my, nor behind the coin­ci­dence that neg­a­tive FIRE prof­its have occurred only dur­ing the Great Depres­sion and our cur­rent cri­sis (see Fig­ure 11).

Fig­ure 11: The FIRE Econ­o­my vs the Real Econ­o­my

But lend­ing is a two-sided activ­i­ty: the non-bank pub­lic has to be a will­ing par­tic­i­pant if debt lev­els are to rise faster than income, and ulti­mate­ly reach lev­els that can cause a finan­cial cri­sis.

This always requires the prospect of gain from lever­aged spec­u­la­tion on asset prices, since the public—both house­holds and firms—rarely bor­row exces­sive­ly on the basis of income alone. A break­down of house­hold debt makes this point: as Fig­ure 12 illus­trates, despite all the entice­ments to per­son­al debt, it changed very lit­tle rel­a­tive to income, where­as mort­gage debt has risen dra­mat­i­cal­ly over time.

Fig­ure 12: Only Mort­gage Debt has risen sub­stan­tial­ly

To pre­vent bub­bles, we there­fore have to reduce the appeal of lever­aged spec­u­la­tion on asset prices, with­out at the same time chok­ing off demand for debt for either legit­i­mate invest­ment or unavoid­able bor­row­ing. I pro­pose two mech­a­nisms: “Jubilee Shares” and “Prop­er­ty Income Lim­it­ed Lever­age” (“The PILL”):

Jubilee Shares: To rede­fine shares so that, if pur­chased from a com­pa­ny direct­ly, they last for­ev­er, but after a min­i­mal num­ber of sales (say sev­en), they become Jubilee Shares that last anoth­er 50 years before they expire; and

Prop­er­ty Income Lim­it­ed Lever­age: To lim­it the debt that can be secured against a prop­er­ty to ten times the annu­al rental of that prop­er­ty.

Jubilee Shares

Cur­rent­ly, 99% of all trad­ing on the stock mar­ket involves spec­u­la­tors sell­ing pre-exist­ing shares to oth­er spec­u­la­tors. This is under­tak­en with bor­rowed mon­ey in the hope of exploit­ing price bub­bles like that set by Yahoo! in the Dot­Com Bub­ble (see Fig­ure 13), when that the lend­ing itself large­ly caus­es the price bub­bles.

If instead shares on the sec­ondary mar­ket last­ed only 50 years, then even the Greater Fool could­n’t be enticed to buy them with bor­rowed money–since their ter­mi­nal val­ue would be zero. Instead a buy­er would only pur­chase a share on the sec­ondary mar­ket in order to secure a flow of div­i­dends for 50 years (or less). One of the two great sources of ris­ing unpro­duc­tive debt would be elim­i­nat­ed.

The objec­tive of this pro­pos­al is to make lever­aged spec­u­la­tion on exist­ing shares unat­trac­tive, while still mak­ing fund­ing IPOs and share issues attrac­tive, and enabling gen­uine price dis­cov­ery.

Fig­ure 13: Yahoo’s share price bub­bles and bursts

Property Income Limited Leverage

Some debt is need­ed to pur­chase a house, since the cost of build­ing a new house far exceeds the aver­age wage. But debt greater than per­haps 3 times aver­age annu­al wages dri­ves not house con­struc­tion, but house price bub­bles.

Prop­er­ty Income Lim­it­ed Lever­age (“the PILL”) would break this pos­i­tive feed­back loop by bas­ing the max­i­mum that can be lent for a prop­er­ty pur­chase, not on the income of the bor­row­er, but on a mul­ti­ple of the income-earn­ing poten­tial of the prop­er­ty itself.

With this reform, all would-be pur­chasers would be on equal foot­ing with respect to their lev­el of debt-financed spend­ing, and the only way to trump anoth­er buy­er would be to put more non-debt-financed mon­ey into pur­chas­ing a prop­er­ty.

It would still be possible–indeed necessary–to pay more than ten times a prop­er­ty’s annu­al rental to pur­chase it. But then the excess of the price over the loan would be gen­uine­ly the sav­ings of the buy­er, and an increase in the price of a house would mean a fall in lever­age, rather than an increase in lever­age as now. There would be a neg­a­tive feed­back loop between house prices and lever­age. That hope­ful­ly would stop house price bub­bles devel­op­ing in the first place, and take dwellings out of the realm of spec­u­la­tion back into the realm of hous­ing, where they belong.

Conclusion

I hope that my Min­sky-inspired analy­sis of the source of finan­cial mar­ket insta­bil­i­ty is com­pelling; I expect that my reform pro­pos­als are less so. But they are not so much rad­i­cal as born from a real­is­tic assess­ment, not only of the cause of finan­cial insta­bil­i­ty, but the his­tor­i­cal record of our past attempts to tame it.

We can­not rely upon laws or reg­u­la­tors to per­ma­nent­ly pre­vent the fol­lies of finance. After every great eco­nom­ic cri­sis come great new insti­tu­tions like the Fed­er­al Reserve, and new reg­u­la­tions like those embod­ied in the Glass-Stea­gall Act. Then there comes great sta­bil­i­ty, due large­ly to the decline in debt, but also due to these new insti­tu­tions and reg­u­la­tions; and from that sta­bil­i­ty aris­es a new hubris that “this time is different”—as the debt that caus­es crises ris­es once more. Reg­u­la­to­ry insti­tu­tions become cap­tured by the finan­cial sys­tem they are sup­posed to reg­u­late, while laws are abol­ished because they are seen to rep­re­sent a bygone age. Then a new cri­sis erupts, and the process repeats. Min­sky’s apho­rism that “sta­bil­i­ty is desta­bi­liz­ing” applies not just to cor­po­rate behav­iour, but to leg­is­la­tors and reg­u­la­tors as well.

Jubilee Shares and the PILL are an attempt to write restraints on Ponzi Finance into the fab­ric of our soci­ety, so that bub­bles do not form in the first instance, so that the pos­i­tive feed­back loop that turns ris­ing asset prices into accel­er­at­ing debt does not hap­pen, and so that anoth­er finan­cial cri­sis like the one we are now in nev­er occurs again.

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.

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